Citigroup Has Higher Hurdle as Fed Adds China Slump to Tests

The Fed will conduct its own tests on the 19 largest institutions, including Citigroup Inc., JPMorgan Chase & Co. and Bank of America Corp. The remaining 11 firms will test themselves and submit results to the central bank. Photographer: Andrew Harrer/Bloomberg

Nov. 16 (Bloomberg) -- The Federal Reserve changed its
annual set of tests for the 30 largest U.S. banks to incorporate
the risk of a deeper slump in Asia, where Citigroup Inc. has a
bigger presence than competitors.

Recessions in the euro area, the U.K. and Japan are
features of the Fed’s “severely adverse” scenario in the new
test. The main difference from last year is a more substantial
slowdown in Asia, including “a sizable weakening of economic
activity in China,” the Fed said yesterday in a statement.

Citigroup, the third-biggest U.S. bank, employs thousands
of people across Asia. Former Chief Executive Officer Vikram
Pandit, originally from Nagpur, India, pushed into markets
across the continent, making credit-card, personal and corporate
loans in countries such as China, India and Singapore.

“Citi has the most obvious gross exposure to a slowdown in
Asia,” said David Knutson, a Chicago-based credit analyst with
Legal & General Investment Management America. “My expectation
is that Citi has gone a long ways over the last six to eight
months to educate the Fed on the types of risks they’re taking
in international markets.”

Pandit, 55, was pushed out by the board last month, a
decision driven in part by the bank’s failure to get its capital
plan approved by the Fed after the last stress tests, a person
familiar with the matter said in October. Michael Corbat, who
succeeded Pandit, said in an Oct. 16 conference call with
analysts that submitting a new capital plan to the Fed by Jan. 5
is one of the issues “I’m going to spend time focused on.”

‘Pristine’ Assets

The focus on Asia was the “biggest change” to the Fed’s
tests, Goldman Sachs Group Inc. analysts led by Richard Ramsden
said in a note to clients today.

“With around 25 percent of its revenue coming from Asia, C
appears the most exposed here,” the analysts wrote, referring
to Citigroup’s stock market ticker. Ramsden has a buy rating on
Citigroup shares.

Total Asian assets in the bank’s Citicorp division, which
include consumer banking and trading, jumped 33 percent to $356
billion in the three years ended Sept. 30, the company said last
month. Credit-card and retail loans also increased 33 percent to
$89.3 billion. The unit’s profit was $12.4 billion in that span.

Citigroup must prove to the Fed that these are “pristine”
assets that can withstand a downturn in Asia, Knutson said.

“That’s what you want to hear as a regulator, that they
didn’t allow themselves to be led down a dark path in the name
of growth,” said Knutson, whose firm owns Citigroup debt.

Asia Risk

Mark Costiglio, a spokesman for New York-based Citigroup,
declined to comment.

Citigroup should be able to withstand a severe slowdown in
Asia, Bank of America Corp. analysts led by Erika Penala wrote
to clients. While such a slump would be “meaningful” for
Citigroup, it would also be “manageable,” Penala wrote in a
note titled “6 reasons not to panic about Asia stress.”

The lender should pass the Fed’s tests and return about $4
billion to shareholders, according to Penala, who has a buy
rating on Citigroup. Her team of analysts wanted to address
“press articles” implying that the Fed’s focus on Asia would
hurt the bank’s test results, according to the note.

Citigroup fell 1.2 percent to $34.78 at 1:47 p.m. in New
York. The shares have advanced 32 percent this year, compared
with a 19 percent gain in the 24-company KBW Bank Index.

The central bank started the tests in 2009 to restore
confidence in the financial system after the worst crisis since
the Great Depression brought down Bear Stearns Cos. and Lehman
Brothers Holdings Inc. Regulators have since complemented the
reviews with a capital-planning requirement to improve boards’
management of risk and dividend and stock-buyback decisions.

Fare Better

“There will be pain for specific banks” with exposure to
Asia, said Walter Young, a director in Deloitte & Touche LLP’s
governance, risk and regulatory services division who focuses on
stress-testing and is based in Salt Lake City.

Still, most financial firms will fare “generally better
than last year,” Young said. Capital levels are higher and
banks are “learning how to operate with 8 percent
unemployment,” he said.

Citigroup, which pays a one-cent quarterly dividend, is
among lenders with the biggest potential increase in rewards for
shareholders, the Goldman Sachs analysts wrote. The other banks
are Regions Financial Corp., KeyCorp, SunTrust Banks Inc.,
Discover Financial Services Inc. and Northern Trust Corp.,
according to the analysts.

Worst Case

In the worst of three scenarios, U.S. gross domestic
product plunges 6.1 percent in the first quarter of 2013 and the
unemployment rate averages as much as 12.1 percent in the second
quarter of 2014 -- an economic shock on the same scale as last
year’s stress test.

The Fed will conduct its own tests on the 19 largest
financial firms, including Citigroup, New York-based JPMorgan
Chase & Co., and Bank of America, based in Charlotte, North
Carolina. The remaining 11 will test themselves and submit
results to the central bank.

The scenarios were developed in consultation with the
Office of the Comptroller of the Currency and Federal Deposit
Insurance Corp., which will use them for tests of the firms they
supervise.

The adverse scenarios weren’t forecasts and were “designed
to assess the strength and resilience of financial institutions
and their ability to continue to meet the credit needs of
households and businesses,” the Fed said yesterday. In the
worst scenario, real disposable income contracts for five
consecutive quarters, and house prices fall 21 percent from the
third quarter of 2012 to the first quarter of 2015.

‘More Favorable’

The Fed also will test the six biggest U.S. banks against a
global market shock that includes movements in indicators such
as credit spreads and bond yields as well as the market values
of private-equity positions. The six banks -- Bank of America,
Citigroup, Goldman Sachs, JPMorgan, Morgan Stanley and San
Francisco-based Wells Fargo & Co. -- will be given the scenario
by Dec. 1.

The tests should be “more favorable” to Goldman Sachs,
Morgan Stanley and Bank of America because they have less
international operations, analysts at KBW Inc. led by David
Konrad said in a note today. Banks with greater exposure outside
the U.S. will benefit less, the analysts wrote.

Banks “need to make a convincing argument to their
regulators that they know their risks well, take capital
planning seriously, and that they execute capital-planning
competently,” said Jeffrey Brown, a managing director at
Washington-based Promontory Financial Group and former head of
the OCC’s risk-analysis division.

International Agreement

The financial firms will be required to maintain a Tier 1
common equity ratio of 5 percent of assets weighted for risk
throughout the worst-case scenario even with dividend and stock-repurchase plans. Regulators view Tier 1 capital as the most
important for loss-absorption because it’s composed of common
stock and retained earnings.

The 19 biggest banks have boosted Tier 1 common equity to
$803 billion in the second quarter of 2012 from $420 billion in
the first quarter of 2009, the Fed said last week.

U.S regulators are imposing the biggest capital-regime
change on the financial system since the 1988 Basel Accord as
they execute mandates under the 2010 Dodd-Frank Act and prepare
final rules to apply international agreements.

The previous stress tests featured a recession combined
with a 52 percent plunge in stocks and an unemployment rate as
high as 13 percent.

‘Adjust Rapidly’

The Fed said in instructions published last week that it
expects banks will demonstrate how they “can achieve, readily
and without difficulty, the ratios required by the Basel III
framework as it would come into effect in the United States.”

Basel III isn’t a regulation in the U.S. yet. The Fed
issued three proposals related to the new standards in June.
Brown, the former senior regulator at the OCC, said the Fed’s
emphasis on Basel III compliance in the stress test is unusual
given that it isn’t a final regulation.

Still, “market participants are going to expect banks to
adjust rapidly” to the new Basel standards, said Brown, who
advises companies on regulation. “The Fed recognizes that
expectation and wants banks to demonstrate that they are
prepared to meet it,” he said.

Goldman Sachs, the fifth-biggest U.S. bank, would have $728
billion in risk-weighted assets under new capital rules, a 67
percent jump from the amount it had under earlier regulations
and a bigger increase than rivals experienced.

Synergistic, Virtuous

The investment bank plans to cut the figure to $700 billion
by the end of next year by reducing its exposure to credit risk
and market risk, CEO Lloyd C. Blankfein said at a Nov. 13
investor conference.

Goldman Sachs may have an advantage over larger competitors
such as JPMorgan or Citigroup, which include consumer banks as
well as investment banks, because the Basel-based Financial
Stability Board proposed earlier this month that those companies
keep a higher capital buffer than New York-based Goldman Sachs.

“For more than a decade, larger size and complexity were
viewed entirely as synergistic and virtuous,” said Blankfein,
58. “For the first time it’s clear that size and complexity
come with a higher cost.”